Monday, May 9, 2011

Blogger's View of the Fed

The Kauffman Economic Outlook, a survey of economics bloggers, is out for Q2. The survey had two interesting questions on the Fed, one of which I submitted. Thanks to Tim Kane for including it in the survey. Here is the question and the results:

I am not entirely surprised by these results. Most popular accounts and thus the emerging narrative about this experience either downplay or ignore the studies that have shown the monetary policy was a major contributor. I won't rehash them here, but will note that I am editing a book that does shift the focus back to the role the Fed played in the boom and the bust. Stay tuned for more news on the book.

I was very surprised to see the responses to the second Fed question. It was submitted by Bryan Caplan and Steve Miller:

Wow. Only 16% of the economic bloggers believe the Fed has had a net negative effect while 40% think the Fed has been good on balance. This is surprising. These folks need to read the assessment of the Fed by George Selgin, William D. Lastrapes, and Larry H. White.

I think the second question, like many limited poll questions, results in answers that are limited.

Yes, the Fed has made errors. I still think the Fed is better than the gold standard, and we have not had hyper-inflation, or a Great Depression. It is better than the uncertain alternatives. Yes, I would like to try NGDP targeting, right away.

Here's a question: On balance, is the world better off for the US Department of Defense?

I say "yes," although I believe the military needs to demobilize, and Iraqistan has been a horrible folly.

Benjamin, I hope you'll read it. You will be reminded in so doing (1) that the U.S. has had only one "Great Depression," and that it occurred under the Fed's watch, and thanks (many authorities, the Bernank himself included, now concede) to the Fed's bungling; (2) that though we've been spared hyperinflation, we have had much more severe inflation under the Fed, including annualized monthly inflation rates of close to 25% during WWI, than at any time in the pre-Fed gold-standard era; and (3) the present arrangement has itself been far less "certain" than the gold standard, at least w.r.t. price-level movements.

I'm not myself an advocate of trying to force a revival of the gold standard, but i think you will also learn (4) that it is by no means clear that the Fed has generally outperformed the post-Civil War gold standard regime. As Canada's experience illustrates quite clearly, U.S. crises under that regime had more to do with our bad banking regulations than with the gold standard's manner of regulating the stock of basic money.

However, I tend to fall into a camp of people who would rather have 5 percent real growth and 5 percent inflation vs. 1 percent real growth and 1 percent inflation.

For me, there is no honor in nominal price stability, only honor in real growth (taking into account legitimate environmental concerns).

I suspect a modern economy needs inflation, and maybe even higher than 2 percent. Money illusion and all of that. Dutch courage for investors, especially in real estate. An illusion of growth leads to optimism and real growth.

Japan has tried tight money for 20 years and it has been a failure. It can suck the optimism right out of the business class, and maybe even young people (who stop having families). Deflation is economic suicide for a modern economy.

I don't know if you are still checking out this blog entry, but if you are I have read your excellent study (on the CATO site).

I am a layman, but I will give you my views. I did take a lot of econ (back in the gaslamp era) and have been a financial reporter, but I am not a Ph.D.

1. I thought the paper should take a long, hard look at Japan. The paper was a bit USA-centric. If whipping inflation is so great, explain Japan.

2. The notion that price stability is a positive is defended, although footnote number 5 suggests that maybe the gains from price stability are not all that great. The paper does not explore losses from obtaining price stability. Nor does the paper explore that there might be a beneficial rate of inflation, such as 3 percent.

3. I wonder about using older data--pre WWII--to support any arguments, pro- or anti-Fed. I have done some social science research. Data is not all that great, and one can plump results by cherry-picking data.

Additionally, I suspect much greater fractions of the economy were informal in 19th century, and probably right up through WWII. Rural economies that thrive on barter. This must make measurement imprecise. The economy could be growing or contracting in the real world, but in the measured world something else might be happening. Also, something just does not strike me as kosher to compare a 19th century economy to a modern economy. I suspect (economically speaking) Modern Japan has a lot more in common with Modern America, and more lessons to offer, than 19th century America.

4. Getting back to inflation, when I talk to fellow small businesspeople, the biggest topic is never inflation, but demand. Do they have enough business. Can they grow?

The second topic is taxes and regs (and permits--often overlooked in highbrow economic commentary is how repressive local governments are). Financing is somewhere up there too.

I never knew of a business-guy not going ahead on the basis that he didn't know if inflation was going to 2 percent or 5 percent. I have never heard of mild inflation being a disincentive to invest. Sheesh! I suspect mild inflation is an incentive to invest in real estate--though US tax code is a much bigger incentive.

5. I thought you needed to look a lot less at the gold standard, and a lot more at Scott Sumner's NGDP targeting idea. Friedman raised good concerns about gold standards. So did Benjamin Franklin, btw. Crickey, you don't think gold has ranged all over the board since 1980?

To reply very quickly (for I must submit grades this week), like your businessmen I too think demand more important than the price level, which is why I favor a kind of NGDP targeting. (I am a fan of Scott Sumner's ideas partly for this reason.) But if one stabilizes demand, logically the rate of inflation ought to decline when productivity growth accelerates, ceteris paribus. Why, then, believe as you seem to that growth should be positively correlated with inflation? There's surely a tension here, if not an outright contradiction.

More generally, your belief that low inflation and especially deflation must mean low growth is both inconsistent with the evidence and inconsistent with the fact that the relation betwen P and y movements depends on whether they are related to Aggregate Ssupply or Aggregate Demand innovations. In the second case the relation is positive. But in the first it is negative. (On these and related points see my pamphlet, Less Than Zero, available online at the IEA website.

As for gold's recent behavior: if proof of anything it is proof of the instability of fiat regimes and of the inflation fears they can give rise to.

When paper monies were generally linked to gold, gold was stable. To point to recent fluctuations in the gold marked as evidence of the advantages of a fiat regime is really getting things the wrong-way 'round.

Thanks for your pleasant comments. As a layman vs. a Ph.D., I feel I am bringing the short sword into this fight.

Mostly, when I think of deflation, I think of Japan or the USA 2008-9-10. These are not pretty thoughts.

There are theoretical constructs for deflationary growth--but in the modern economy, with wealth tied to real estate, and so many loans made in nominal dollars? People are rational, but they are also social animals.

Would investors really feel good about a DJIA that went down every year? That their house went down every year in nominal value? Sure, intellectually many could adjust. Even loans could be written to accommodate deflation, I imagine.

But in terms of gut feelings? Would deflation breed optimism, or Japan-itis?

On gold: Yes, fiat money can go haywire. On the other hand, even in real terms, gold was ranged around quite a bit in the last 30 years. That suit you could buy for an ounce of gold has lately gotten quite fancy, up from an off-the-rack model a few years back.

Bottom line, I enjoyed your study, and I hope for more stability from the Fed, and the NGDP idea. Thank you for enduring the ideas of a layman, and keep up your very interesting lines of inquiry.

Thanks for your comments, Benjamin. Japan: well, it's a good case of "bad" deflation, as was the U.S. in 2008-9. Nothing we ought to repeat. But the deflations in question were bad precisely because they stemmed from demand shrinkage--or rather slowdowns (as ours is an age in which demand growth, and even fairly rapid growth of 4-5%, has come to be taken for granted). The "good" or supply-driven deflation I refer to has been rare since the 20s, but was relatively common until then. The Fed no longer allows it, any more than it allows P to merely stand still. But that's not a good thing: would that we might have had a mild deflation in 2001-6 instead of the bubble the Fed gave us!

As I mentioned, I go into the good versus bad deflation stuff in detail in my IEA pamphlet, which you can read here.